ARE FIXED INCOME SECURITIES RISK FREE?

Among the common investors, we find a myth that bonds are risk free and investment in equities
is a risky venture. How far this is true? Are bonds really risk free? The purpose of this article is to
understand the real status of bond and equity and to have a better understanding of the issue.
Bond as it is called in common language is the member of fixed income security group.

Fixed income security is the financial obligation of the issuer with the promise to pay a specified
amount of money on a pre-specified date. We find broadly two forms of fixed income securities.
(1) Debt obligation and (2) Preferred stock. In case of debt obligation, the issuer is known as the
borrower and the investor who purchases these securities is known as creditor. Fixed income
securities in the form of debt obligation include bonds, mortgage backed securities, asset backed
securities and bank loans.

On the other hand, the holder of the preferred stock receives dividend payments and has priority
over common stock holder, while receiving dividend payments and liquidation. In the present
article, we shall concentrate on the debt obligation, specifically bonds.

As mentioned in the above paragraph it is often said that investment in bond is risk free, but it is
not true, of course bonds are less risky than equities, but are not completely risk free. Various
kinds of risks are associated with investing in bonds. These risks are deal in the following
paragraphs.

1. Interest rate risk: - Bonds are usually recognized by yields, which change from time
to time owing to many market forces. There exists an inverse relationship between
the bond price and interest rates. When the interest rates rise the bond price decline
and when interest rates decrease the bond price increases. As the price of the bond
fluctuates with market interest rates, an investor is exposed to risk because the price
of a bond held in his portfolio will decline if market interest rate rise.
2. Credit risk: - A bond investor is always exposed to credit risk. We find three kinds of
credit risks such as (I) Default risk (ii) Credit speared risk (iii) Downgrade risk.
Default risk is the risk that arises when the issuer is not able to satisfy the terms and
conditions of the obligation with respect to timely payment of interest and repayment
of the amount borrowed. A credit spread is the difference in interest rate between a
corporate bond and a comparable maturity government bond. The risk related to the
down gradation of the bond by rating agencies is downgrade risk.
3. Liquidity risk: - Liquidity risk is concern with an investor, who wants to sell a bond
even before it reaches its maturity date, would be concerned as to whether he will
receive a price that is close to the true value of the issue.
4. Inflation or purchasing power risk – Inflation or purchasing power risk is the
potential risk or loss in the value of cash due to inflation. It arises from the decline in
the value of a security’s cash flows due to inflation, which is measured in terms of
purchasing power.

Apart from what is mentioned in the preceding paragraph, bond valuation is also affected by
some other kinds of risks, such as volatility risk, event risk, regulatory risk, and political risk. So
is it right to say that bonds are risk free.

Author –

Aniruddha Sunil Gachake

Associate Professor
Renaissance Institute of Management Studies, Chandrapur.
Mail id – asgachake@gmail.com